basic macroeconomic relationships chapter 27 mcgraw-hill/irwin copyright © 2009 by the mcgraw-hill...

BasicMacroeconomicRelationships

Chapter 27

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

27-2

Chapter Objectives

• Effect of changes in income on consumption (and saving)

• Other factors that affect consumption• Effect of changes in real interest rates

on investment• Other factors that affect investment• Changes in investment have a

multiplier effect on real GDP

27-3

Basic Relationships

• What are the two things we can do with our income?–Consume (spend) or Save

• Disposable income (DI)–After taxes

• 45°line for reference–C = DI on the Line–*****turn to pg. 542

• S = DI - C

27-4

Income and Consumption

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

0 2000 4000 6000 8000 10000

Co

nsu

mp

tio

n (

bil

lio

ns

of

do

llar

s)

Disposable Income (billions of dollars)

45° Reference LineC=DI

83

8685

84

8889

9190

87

9293

9495

01

9796

9998

00

02

05

03

04

ConsumptionIn 1992

SavingIn 1992

45°

C

Source: Bureau of Economic Analysis

27-5

Consumption and Saving

• The consumption schedule• The saving schedule• Break-even income• Average propensity to consume

(APC)• Average propensity to save (APS)

APS =SavingIncome

APC =Consumption

Income

Fallacy of Composition

• The false assumption that what is true for a part will also be true for the whole.– Your experience is YOUR experience…

– …Here, we are measuring the aggregate.

• BE CAREFUL NOT TO GENERALIZE BASED ON YOUR OWN EXPERIENCE!!

27-6

27-7

Consumption and Saving

• Marginal propensity to consume (MPC)

• Marginal propensity to save (MPS)

MPC =Change in Consumption

Change in Income

MPS =Change in SavingChange in Income

27-8

Consumption and Saving(1)

Level ofOutput

AndIncome

(GDP=DI)

(2)Consump-

tion(C)

(3)Saving (S)

(1) – (2)

(4)Average

Propensityto Consume

(APC)(2)/(1)

(5)Average

Propensityto Save(APS)(3)/(1)

(6)Marginal

Propensityto Consume

(MPC)Δ(2)/Δ(1)

(7)Marginal

Propensityto Save(MPS)

Δ(3)/Δ(1)

(1) $370

(2) 390

(3) 410

(4) 430

(5) 450

(6) 470

(7) 490

(8) 510

(9) 530

(10) 550

$375

390

405

420

435

450

465

480

495

510

$-5

0

5

10

15

20

25

30

35

40

1.01

1.00

.99

.98

.97

.96

.95

.94

.93

.93

-.01

.00

.01

.02

.03

.04

.05

.06

.07

.07

.75

.75

.75

.75

.75

.75

.75

.75

.75

.25

.25

.25

.25

.25

.25

.25

.25

.25

MPC + MPS = 1 MPC and MPS measure slopes

27-9

500

475

450

425

400

375

45°

Consumption and Saving

50

25

0

370 390 410 430 450 470 490 510 530 550

370 390 410 430 450 470 490 510 530 550

C

S

ConsumptionSchedule

Saving Schedule

Saving $5 Billion

Dissaving $5 Billion

Dissaving$5 Billion

Saving $5 Billion

Disposable Income (billions of dollars)

Co

nsu

mp

tio

n (

bil

lio

ns

of

do

llar

s)S

avin

g(b

illi

on

s o

f d

oll

ars

)

27-10

Average Propensity to Consume

Source: Statistical Abstract of the United States, 2006

Selected Nations, with respect to GDP, 2006

United States

Canada

United Kingdom

Japan

Germany

Netherlands

Italy

France

.80 .85 .90 .95 1.00

27-11

What do you notice about the early 2000’s?

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

0 2000 4000 6000 8000 10000

Co

nsu

mp

tio

n (

bil

lio

ns

of

do

llar

s)

Disposable Income (billions of dollars)

45° Reference LineC=DI

83

8685

84

8889

9190

87

9293

9495

01

9796

9998

00

02

05

03

04

ConsumptionIn 1992

SavingIn 1992

45°

C

Source: Bureau of Economic Analysis

27-12

Non-income determinants of consumption and saving

• Wealth – When wealth suddenly increases, people consume

more

• Borrowing– Easy credit increases consumption, sometimes

above disposable income…but debt needs repaid in the future

• Expectations• Real interest rates

27-13

Consumption and Saving

• Other important considerations

–Switch to real GDP

–Changes along schedules

–Schedule shifts

–Stability

–Taxation

27-14

45°

Consumption and Saving

C0

S0

Disposable Income (billions of dollars)

Co

nsu

mp

tio

n (

bil

lio

ns

of

do

llar

s)S

avin

g(b

illi

on

s o

f d

oll

ars

)

C2

C1

S1

S2

27-15

Interest Rate and Investment

• Expected rate of return (r)

• The real interest rate (i) –Nominal rate less rate of inflation

• Meaning of r = i–Firms will invest as long as r ≥ i

• Investment demand curve

27-16

Investment Demand Curve

ExpectedRate of

Return (r)

CumulativeAmount ofInvestmentHaving This

Rate ofReturn or Higher

(I)

16%14%12%10%

8%6%4%2%0%

$ 05

10152025303540

r a

nd

i (

pe

rce

nt)

16

14

12

10

8

6

4

2

05 10 15 20 25 30 35 40

Investment (billions of dollars)

ID

27-17

Investment Demand Curve

• Shifts of the curve–Acquisition, maintenance, and

operating costs

–Business taxes

–Technological change

–Stock of capital goods on hand

–Planned inventory changes

–Expectations

27-18

r a

nd

i (

per

cen

t)

0

Investment (billions of dollars)

ID0ID1ID2

Increase in Investment Demand

Decrease in Investment Demand

Investment Demand Curve

27-19

Investment Demand

• Instability of investment–Durability

–Irregularity of innovation

–Variability of profits

–Variability of expectations

27-20

Gross Investment Expenditure

Source: International Monetary Fund

Percent of GDP, Selected Nations, 2006

South Korea

Japan

Canada

Mexico

France

United States

Sweden

Germany

United Kingdom

0 10 20 30

Volatility of Investment

Source: Bureau of Economic Analysis

27-21

27-22

The Multiplier Effect

Multiplier =Change in Real GDP

Initial Change in Spending

• More spending results in higher GDP

• Initial change in spending changes GDP by a multiple amount

Change in GDP = Multiplier x Initial Change in Spending

27-23

The Multiplier Effect• Causes of the initial change in spending

–Most prevalent - Changes in investment• Become increases in wage, rent, interest, profit

–Other changes – C, G, X• Rationale

–Dollars spent are received as income– Income received is spent (MPC)– Initial changes in spending cause a

spending chain

27-24

(1)Change in

Income

(2)Change in

Consumption(MPC = .75)

(3)Change in

Saving(MPS = .25)

Increase in Investment of $5Second RoundThird RoundFourth RoundFifth RoundAll other rounds Total

$ 5.003.752.812.111.584.75

$ 20.00

$ 3.752.812.111.581.193.56

$ 15.00

$ 1.25.94.70.53.39

1.19$ 5.00

Rounds of Spending1 2 3 4 5 All

$20.00

15.2513.67

11.56

8.75

5.00$5.00

$3.75

$2.81

$2.11$1.58

$4.75

ΔI=$5 billion

The Multiplier Effect

27-25

The Multiplier Effect

Multiplier =1

1 - MPC

Multiplier =1

MPS

-or-

27-26

The Multiplier and the MPC

10

5

4

3

2.5

.67

.75

.8

.9

MPC Multiplier

27-27

Squaring the Economic Circle

• Humorist Art Buchwald and the multiplier

• Suppose one person can’t buy a product

• Others subsequently impacted and cannot buy other items

• Multiple effects impact psyche• Ultimately causes multiple step impact

upon the economy as a whole

27-28

Key Terms

• 45°(degree) line• consumption

schedule• saving schedule• break-even income• average propensity

to consume (APC)• average propensity

to save (APS)

• marginal propensity to consume (MPC)

• marginal propensity to save (MPS)

• wealth effect• expected rate of

return• investment demand

curve• multiplier

27-29

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The AggregateExpenditures Model